The U.S. Economic Crisis: Root Causes and the Road to Recovery

Many attribute the beginning of the
financial crisis to the collapse of the housing market. While the
housing bust indeed plays an important role, particularly in the
health and stability of the banking sector, the real problem is
deeper. The fluctuations observed across real estate markets over
the last decade or so simply reflect sizable macroeconomic
imbalances. It is the nature of these imbalances that we must
fully appreciate to better understand the crisis and to
potentially forecast plausible scenarios going forward. At the
broadest level, we have witnessed a consumption boom over the last
two decades, where U.S. aggregate household consumption grew to
represent more than 70% of gross domestic product (GDP), a
historically and unsustainably high level (see Exhibit 1).

Excessive
consumption was fueled by a loosening of lending standards prompted
by government policy to increase homeownership rates, and
accompanied by record low savings rates.
Cheap credit from both home and abroad and a substantial increase
in financial intermediation including new structured derivative
products also contributed. In line with the private sector, the
U.S. government also ran sizable budget deficits and a huge
current account deficit.

Collectively,
the expansion of credit yielded levels of U.S. household
indebtedness and corresponding decreases in household savings, as a
percentage of disposable income, that were also unprecedented (see
Exhibits 2 and 3). In other words, U.S. consumers and policymakers
have been financed to a significant degree by borrowing from abroad
(and, by default, from future generations). Simply put, the U.S.
economy, financed by excess credit, spent more than it earned.

STRUCTURAL CHANGES ARE REQUIRED

The
long-term implications of these factors are significant. Perhaps
more importantly, a thawing of credit markets will not on its own
portend a rapid economic recovery in output growth and employment.
It is likely that the economy will not enjoy a healthy recovery
until these long-run imbalances are rectified. In fact, given these
long-run challenges, a swift recovery could be undesirable. If a
rapid recovery merely reflects a temporary return to the levels of
excess consumption and debt, we would only have delayed adjustments
with a potentially larger economic cost down the road.

Using
IMF data, the table in the next column provides historical evidence
that economic contractions associated with financial crises tend to
be deeper and last longer than recessions not associated with a
financial shock. Accordingly, we conjecture that the outcome with
the highest probability is an L-shaped economic pattern, where the
economy finds its footing perhaps as early as the second half of
2009, but muddles along for some time with significant excess
capacity and unemployment.

Recession Durations and Amplitudes Across Industrialized Countries

Average number of quarters

Percentage change in real GDP

All
Recessions

3.64

-2.71%

Recessions Associated With a Financial Crisis

5.67

-3.39

All Other
Recessions

3.36

-2.61

JOBS?

We
project one measure of excess capacity, the “output gap,” reflecting
the degree to which actual economic activity diverges from the
potential implied by optimal capacity utilization, to significantly
expand before narrowing (see Exhibit 4).

Unemployment,
clearly among the most important indicators for the general
well-being of typical Americans, is a lagging indicator, and the
green shoots of good news that are emerging will come well in
advance of any turnaround in employment trends. U.S. unemployment is
already at a 25-year high, and may exceed and remain above 10% for
some time.

We
project unemployment will be structurally higher in the near term
and only decline slowly over many years as adjustments are made in
the skills of the labor force. This prediction stems from the
inherent mismatch between skills available in the labor force
currently, which are tilted toward a high level of U.S. consumption,
and the skills necessary to drive sustainable growth over the next
five to 10 years.

FINANCIAL INVESTMENT

To
rebuild the economic foundation for sustainable long-term growth,
the U.S. economy needs higher levels of financial and real
investment. Financial investment means
that the savings rate must increase significantly to start
generating household wealth sufficient to deal with retiring baby
boomers, increased health costs, etc. This transition will hamper
near-term growth given the importance of consumption to the U.S. economy.

Real
investment is needed to create the infrastructure that will generate
wealth and support the future needs of retirees. Specifically, the
U.S. economy needs to invest in health care infrastructure, basic
R&D, as well as high-margin service and manufacturing sectors
because these will meet the needs of the global (and U.S.) economy
over the coming decades. Recent investments in consumer
discretionary industries and residential construction have been
excessive (and returns have been disappointing). Investments in
future growth industries are facilitated by capital spending by
corporations, but just as importantly through education, job
retraining and public infrastructure expansion.

It is
important to note that any discussion about real investment is
largely about long-term growth. As we discuss below, this presents
an inherent challenge to the economy in the short run. Investment
requires savings, and savings requires income. However, income
growth is likely to be limited in the short run because of the weak
economy and the decline in household wealth. Baby boomers, in
particular, face increasingly dire circumstances as stocks and real
estate have performed poorly in the last decade. In short, the
change we see coming will be a long process even though the economic
restructuring that will lead to growth is likely to start this year.
And, we should not count on the recovery being led by consumer
spending. In fact, we should expect consumption growth to be on
average below the overall GDP growth rate for some time.

INFLATION OR DEFLATION?

During
this difficult transition, the economy is likely to remain below
potential output levels for some time. Accordingly, we should expect
inflation to remain low (indeed, deflation is the bigger risk for
the near term). That said, given the tremendous amount of monetary
stimulus provided by the Federal Reserve, long-run inflation risks
are present. These risks are less likely to be a major problem as
the Fed will be poised to drain liquidity from the system as the
economy begins to show signs of growth.

However,
a second risk to our forecast that should be clearly acknowledged is
an awareness that the Federal Reserve will be required to act
swiftly in the early stages of the turnaround. Indeed, the Fed will
be forced to initiate monetary tightening while unemployment is
still at relatively elevated levels, which will no doubt generate
significant ire among elected officials.

WHAT WILL JUMP-START GROWTH?

One
likely possibility is that the U.S. current account deficit will
turn to a balanced position (or even a surplus). This has already
started to happen as a reduction in U.S. consumer demand (as well as
falling import prices) have significantly reduced the trade deficit.
This is good for the U.S. in the short run but not a sustainable
path for long-term U.S. growth. Instead the U.S. will need to foster
export growth as opposed to relying on declines in imports as
foreign (especially developing) economies rebound.

A
second method for combating the significant slowdown in
private-sector demand will come from government spending growth that
is expected to be above trend in the near term. However, it is
important to understand that, after a few years, the government will
be forced to rein in spending. This fiscal contraction will retard
growth in the intermediate term. The uncertain pace of a retreat in
government spending represents a significant risk to our outlook in
that this requires restraint by policymakers. Under the president’s
proposed budget, the Congressional Budget Office (CBO) forecasts
that government debt held by the public, as a percentage of GDP,
will increase significantly in the next decade (see Exhibit 5); for
historical comparison, these levels were last touched during World
War II.

Furthermore,
government policy still eventually has to deal with the increasingly
impending unfunded liabilities. Social Security, Medicare/Medicaid,
and the prescription drug benefit, with their estimated unfunded
liabilities of around $40 trillion to $50 trillion, stand in sharp
contrast to the current total federal debt of about $11 trillion and
the projected $1 trillion to $2 trillion federal deficits for 2009
and 2010. The CBO forecasts that government debt held by the public
will exceed 200% of GDP in several decades. There is perhaps no more
important issue going forward.

ROLE FOR POLICY

To
thaw credit markets, the current wave of financial bailout packages
is a necessity. This does not contradict our view on the primacy of
the long-run challenges the U.S. economy faces. The financial system
is the lifeblood of the U.S. economy, and its smooth functioning is
a necessary component of an eventual turnaround. Nonetheless, the
policy prescriptions should involve a substantial cost to both
equity and bondholders. While equity holders have been penalized, it
appears thus far that many bondholders have escaped significant
pain. This creates as serious a moral hazard problem as bailing out
equity holders.

Going
forward, it will be necessary to clean up the financial system and
improve the quality of regulation and oversight, but this is not
what is restraining economic activity right now. Even if bank credit
problems were widely solved, fewer households and businesses would
(and should) qualify for credit and those with good credit will
likely demand less. Financial market stabilization is a necessary
goal, but it does not speak to our long-run challenges.

The
current fiscal stimulus package, despite some important components,
may not be the best approach. Many current spending proposals would
be better dealt with through alternative policy prescriptions. In
the face of a significant economic downturn, federal support for
unemployment benefits, job retraining, education, and investment tax
credits are warranted. However, subsidies (direct or indirect) for
additional consumption and residential investment stand in the face
of a long-run adjustment on private-sector consumption that needs to
happen. The Keynesian injection of public-sector demand is designed
to replace—and eventually restimulate—private-sector demand. While
economists and policymakers intensively debate the merits of this
idea intellectually, it would be a shame to have much of the
increase in government spending wasted as part of a turnaround
effort that just leaves U.S. households in an even more precarious position.

Finally,
we believe that the entire restructuring process will come at a
substantial cost to us all. The mind-set that consumption and
government expenditures do not carry costs has pervaded the U.S.
economy for too long. Steps forward should focus on facilitating a
greater balance to the economy, spanning the household, government
and external sectors. Greater rates of taxation and lower spending
(or, in the worst case, higher inflation) at the end of all this
will be required once the economy has stabilized. We can perhaps
continue to spend beyond our means for a bit longer, but this will
not persist indefinitely. Policies designed to avoid the pain of
this transition will only exacerbate the eventual costs for future
generations. The legacy of past policies already posts a significant
roadblock for economic growth going forward. As the most important
example, we need to deal with unfunded liabilities now.

CONCLUSIONS

Nothing
here is particularly pleasant, but it is necessary. The only other
panacea imaginable is an unusually high long-run economic growth
rate over the next few generations. Long-run improvements in
standards of living are really only achieved with elevated levels of
investment and, most importantly, technological advancements that
stimulate productivity. The U.S. remains among the most innovative
and flexible economies in the world. To maintain that status, the
importance of investment in innovative technologies, education, and
job training cannot be understated.

EXECUTIVE SUMMARY

The root cause of the economic crisis is excessive
consumption accompanied by record low savings rates and
huge budget and current account deficits.

Thawing credit markets alone will not mean a rapid economic
recovery in
output growth and employment.

Unemployment will remain high in the near term and
only decline slowly over many years as adjustments are made in the
skills of the labor force.

Expect inflation to remain low in the near term. Inflation
risks will be present in the long run as the result of monetary
stimulus provided by the Federal Reserve.

The
current fiscal stimulus package may not be the best approach since
it ignores the need to reduce consumption relative to income.

Higher tax rates and lower spending will be required once
the economy has stabilized.

Gregory
W. Brown (gregwbrown@unc.edu) is a
professor of finance and the Sarah Graham Kenan Distinguished
Scholar, and Christian Lundblad (christian_lundblad@unc.edu)
is the Edward M. O’Herron Distinguished Scholar and associate
professor of finance—both at the Kenan-Flagler Business School of
the University of North Carolina at Chapel Hill.

To
comment on this article or to suggest an idea for another article,
contact Matthew Lamoreaux, senior editor, at mlamoreaux@aicpa.org or 919-402-4435.

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